When the Dust Settles

Article, New Law JournalAugust 2010

Insurance / Financial Lines

James Stanbury and Mark Jennings of RGL’s London office examine ash cloud liability & losses.

The eruption of Eyjafjallajokull on 14 April 2010 and ensuing airspace restrictions has caused well-reported disruption and financial losses to the aviation industry. The recent slowdown in the ferocity of the eruption coupled with relaxation of the maximum permissible volcanic ash concentrations has resulted in a return to “normal” services. Now that the dust has settled, it is interesting to analyse not only what recovery options have been suggested as available to airlines but also how such losses may be calculated.

A business interruption policy that may have been bought by an airline, unless there are specific extensions, will normally only respond when there is physical damage. Thankfully, the volcanic ash did not result in such damage but did in airspace restrictions due to obvious concerns and thus, insurers have not been obliged to pay on losses that have been incurred.

This is also the situation for passengers who are also generally unable to recover costs from personal travel insurance policies as the “extraordinary circumstances” exclusion would tend to apply. However, passengers are able recover the costs of sustenance and hotel accommodation (provided they are reasonable) under Article 9 of Regulation (EC) 261/2004. These costs, much to Michael O’Leary’s failed protestations and ensuing fines, are picked up by the airlines themselves.

Much was made in the press by certain airlines of what compensation should be provided by the European Commission and/or federal governments. The 9/11 attacks provided some reference points.

The UK Government, in conjunction with the EC, provided State Aid for the losses which airlines suffered in the period of airspace shut-down after the attacks. Quantification was based on the revenue earned on corresponding days of the former week, net of saved operating costs plus any increased costs of working.

Under the Air Transportation Safety and System Stabilization Act of 2001, the US. Government, in addition to providing loan guarantees, provided airlines $5billion in aggregate compensation for direct losses resulting from the federal ground stop order and for ongoing losses incurred up to and including 31 December 2001.

Of course, there are obvious and hugely important human differences between the events of 9/11 and the Ash Cloud. In terms of economics and demand for travel, whereas the Cloud resulted in temporary closure of airports, it has not resulted in decreased demand for air travel. Conversely, increased fear following the 9/11 attacks decreased demand and introduced lasting challenges to the industry.

This difference, in conjunction with government finances being under increasing pressure, has undoubtedly resulted in, certainly, the UK Government having been silent in compensating the airlines.

It has been suggested that airlines may consider bringing actions against government agencies including the Met Office and the National Air Traffic Control Service, which were instrumental in closing the skies. Whether or not such an action would be successful is unclear.

In any event, airlines suffer losses though accidents on a frequent basis without the need for an ash cloud. So how do we measure these losses?

Lost revenue

Lost revenue is usually calculated as the shortfall of actual revenue against expected or projected revenue. Historic operating and financial data, while providing useful insight into the economics of an airline operation, may not necessarily be the most appropriate source to project expected revenue. The aviation industry is dynamic and fleets rarely remain constant. Historic results therefore may not necessarily accord with current or future plans.

A key factor in the success of an airline is the maximisation of aircraft utilisation and of seat occupancy and ticket prices. Unfortunately, unless demand outstrips supply, the two are not mutually exclusive and one is often maximised at the expense of the other.

Given these issues, it can be useful to review budget and forecast data, which may reflect some of these plans. However, the airline's own projections would also have to be closely reviewed for their underlying assumptions and the extent to which they are achievable.

Passenger airlines can be particularly sensitive to the economic climate, which may not be foreseeable at the time the forecast is prepared and would need to be taken into account when projecting expected revenue. Further consideration should also be given to any other factors, be they internal or external, which would affect financial performance - a clear example of this is the ongoing strikes BA continues to experience. It may also be beneficial to benchmark expected revenue against a comparator airline.

Lost profits

In terms of measuring loss of profits arising out of lost revenue, one should consider each cost category separately to obtain an understanding of what costs may be saved as a result of the subject incident.

The majority of an airline’s operational costs are fixed and therefore will continue to be incurred irrespective of an incident. However, variable costs such as fuel costs, airport charges and navigation charges will be saved if a flight is cancelled and should, therefore, be deducted from the calculation of lost revenue.

It is also important to distinguish between cancelled flights and flights which occur as planned but with a reduced number of passengers. In the latter, the variable costs, which vary based on the number of flight hours and/or landing, will still be incurred. However, the cost per passenger will increase (as a result of the same costs being spread over fewer passengers) and the airline may suffer not only a loss of revenue as a result of depressed ticket sales, but also an erosion of margin on actual revenue. Each loss must be reviewed on a case-by-case basis and with a good understanding of both the industry and the affected airline's specific operating profile.

Mitigation

In the current circumstances, where there has been a blanket ban on flying, it is difficult to see how mitigating actions could apply unless the airline was part of an integrated travel company which also offered train services which benefitted from passenger transfers.

However, one could envisage a post-event “bounce” from pent-up demand. This could manifest itself as increased seat occupancies or an increase in ticket prices. If this were to be the case, any benefit would need to be deducted from the claim.

One should also consider whether an aircraft was imminently scheduled to undergo a maintenance overhaul. If it were possible to bring the maintenance forward such that it could be completed during, say an airspace closure, a saving may also be taken.

The Ash Cloud has brought into sharp focus the economics of airlines – and quite possibly will continue to do so in months/years to come. Establishing losses from these events or any incident brings into play many factors, the quantification of which can prove just as demanding.

 

As appeared in New Law Journal, August 2010.

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